Economist: World's 8th-biggest economy nears fiscal oblivion

THE ECONOMIST

Updated 10:00 pm, Tuesday, January 13, 2009

Arnold Schwarzenegger was skiing in Idaho when his office released a detailed outline of California's 2009-10 budget. It would be unfair to suggest that the governor is unconcerned about the state's dire fiscal situation. On the contrary, he has tried to focus minds on it for months. But the episode does, perhaps, hint at how seriously he expects his proposed solution to be taken.

California, first in many things, is facing America's worst budget crisis. The gap between projected revenues and spending during this fiscal year and next amounts to $41.6 billion, which is almost half the total sum that the state expects to raise next year.

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Unlike the federal government, California is not allowed to get out of the jam by running a deficit. It is finding it hard to borrow to meet even short-term needs. Infrastructure work has virtually stopped.

If nothing is done to close the gap soon -- and perhaps even if it is -- the state will begin issuing IOUs as early as next month.

Recession triggered the crisis but did not cause it. California relies heavily on income taxes, especially those paid by the top 1 percent of earners. These veer up and down with the markets. But instead of saving money in boom years, the state locks in higher spending on public services and embarks on projects that need long-term investment.

Dave Cogdill, head of the Republicans in the state Senate, likens it to a family that adopts children in good times, only to find that it cannot afford to feed them when the economy sours.

Schwarzenegger's solution, which he will describe in detail later this week, combines swinging spending cuts (even to normally inviolable schools) and equally swinging tax increases. He wants to lift the sales tax by 1.5 percent until 2012. This would take it to between 8.75 percent and 10.25 percent, depending on where one is in the state.

Although painful, the governor's proposed budget is still rather optimistic. It assumes, for example, that federal spending on infrastructure will jump, that the cost of fighting fires will be less than half of what it was this year, and that the state will be able to sell $5 billion in bonds by July.

The plan anyway faces crippling opposition in the state Capitol. The Democrats who dominate both houses of the legislature find deep cuts to education and health care unpalatable.

The Republicans, who can muster enough votes to block the governor's budget, refuse to consider tax increases unless they are accompanied by a root-and-branch overhaul of state finances and a mass sell-off of state assets. The divide between the two camps is as wide as Yosemite Valley.

The Democrats have devised a plan to get around this problem, albeit a desperate and legally questionable one. They want to relabel many taxes as "fees" and increase them. Although it takes two-thirds of legislators to pass a tax increase, fees could be increased by a simple majority vote.

Republicans, who have more than a third but less than half of the seats in both chambers of the legislature, would be overridden. Schwarzenegger vetoed the Democrats' proposed budget last week, although he did not reject their ruse in principle.

As the politicians squabble, the budget hole deepens. The governor has put a deficit counter on his Web site, like the national debt clock in New York. It does not appear to be concentrating minds.

Noreen Evans, a Democratic member of the state Assembly, cannot see how the deadlock can be broken: "I'm known in the Capitol as a Pollyanna, and I'm losing hope."